Closer to the Heart

To be an effective trader, you have to understand charts. There are many different ways to use charts, and chart reading is much more art than a science, but charts are indispensable to traders navigating the market.

Thousands of books and articles offer insight on how to use charts, but many market players never really understand why a chart is so valuable. Obviously, charts help uncover repeating patterns, but at their core, charts are about psychology and emotion.

Charts have predictive value because people have emotional reactions to the movement of a stock. If someone buys a stock and sees a gain, that stock is viewed much differently than one that results in a loss.

Investors who focus on fundamentals and value often dismiss charts, saying they don't care where a stock has been; they want to know where it is going. What they overlook is that where a stock has been greatly influences where it is going because existing shareholders remember what they paid for a stock. Ultimately, what really matters to people is whether they have a profit or a loss.

Let's assume one basic idea: When someone holds a stock for a decent gain, there's less inclination to sell than someone holding a stock at a loss. That may be overly simplistic, but it should be clear how a chart might be of assistance here. It helps to think about this on an individual level. Assume someone hears about a great stock on television. They like the story and the excitement of the pundit pushing it, so they jump in and make a sizable buy. Instead of heading higher, the stock goes straight down. Undeterred by their poor timing, they decide to average down and now have twice as many shares. Despite this bullish confidence, the stock continues to fall and now our investor is sitting on a hefty loss and is losing sleep over this impulsive investment.

Typically, someone in this position will start to think, "I need to get rid of this thing. If I can get my money back, I'm going to unload this dog and never look at it again." Finally, the stock bounces and our investor breathes a sigh of relief as the loss shrinks and the investment is almost back to even. Rather than think about all the reasons for buying this stock in first place, and how it can go even higher, our investor is happy to sell and escape the stress that it caused.

That is what chart readers call "overhead resistance." Of course, it is much more complicated when there are thousands of people who bought for various reasons, at different times, and have different emotional reactions. But the basic idea is that when a stock dips and then comes back to a point where many people bought it, there is likely to be selling pressure.

It's helpful to think about how an individual will feel about a stock as it moves. What is someone who bought Apple (AAPL) at the beginning of the year at $550 thinking as the stock breaks $400 now? Buy more? Or is his or her confidence so shaken as to be looking for a way out?

On the other hand, what is the typical feeling of investors who hold a stock hitting an all-time high? No one has a loss, and many have substantial gains. Some will be nervous about protecting profits, but many will be greedy and hold tightly in hopes of further profits, which is what upside momentum is all about.

Charts provide a very interesting insight into market psychology, but they can be very useful for developing a disciplined approach to trading. Good traders need to have a set of rules for taking profits and cutting losses. Charts can give you parameters like a moving average line or a previous high or low -- which is a resistance or support point -- that can be used to guide trading.

Traders use charts because they have predictive value, but also because they help manage a trade once they are in it. The easiest way to get in trouble with a trade is to ignore price action in hopes that the market is failing to understand fundamentals.

I'll write more about the use of charts in future columns, but using them as a window into the emotions of traders will help you to better understand why stocks move in the manner that they do.

At the time of publication, Rev Shark had no positions in the stocks mentioned.